Home Depot- Dividend Discount Model and Intrinsic Valuation Methods - Example

Company overview Home Depot (NYSE:HD) basically is a home enhancement store with an impressive market capitalization of more than $100 billion. The store has more than 2,200 outlets in different locations ranging from the US to Guam, Canada and Puerto Rico. Home Depot on average has stores spanning 128,000 square feet, with 24,000 square feet set aside for outside gardening –centered space. Home Depot with such a huge coverage and numerous stores is an easily identifiable home enhancement base brand. Dividend Discount Model Whereas there are those who believe that HD has made its run and therefore somewhat overbought, there others who think that it is an excellent bet for growth. Nevertheless, I do not wish to comment whether HD is oversold or overbought, but rather come up with a pragmatic dividend discount model which offers an intrinsic value that can be utilized by investors as a yardstick for measuring when they may be willing to take a position in Home Depot. The following is a 6 year PRAT model that represents profit margin, retention rate, assets as well as financial leverage, respectively. By use of the PRAT model, an individual can determine the dividend growth rate, ROA or ROE, or overall, a DuPont Analysis easily. The needed rate of return is determined using CAPM below, in addition to summing up the dividend yield. The anticipated return is the sustainable rate of growth provided the average 6 year retention rate as well as the average 6-year ROE. My computation of the anticipated risk-free rate is a bit unconventional; nevertheless, analysing a 10-year yield historical chart, I discovered that it normally takes roughly 7.5 years on average to realize 100 bps. Thus, ten years, gives a rise of 133.33 bps. With the present yield of 2.40 percent, this would be equivalent to an assumed risk-free rate of 3.73 percent. My technique of computing the matching Dgr’s after 2013 end of year is by use of a reasonably simplistic technique. I utilized a 3-stage model, of which, for the year that follows 2013, or the end of the fiscal year, we notice an average change in the growth rate of dividend provided the initiative of Home Depot to raise buyback for the 2014 fiscal year. Thus, with this, I take into consideration the average change in Dgr for the previous 6 years, and forecast this rise in 2014 growth. Afterwards, I computed the Gordon model dividend rate of growth for the terminal year (fifth year) and used linear interpolation to determine the Dgr between the first and fifth years. In my previous article I had claimed that HD was a fair pick since as the housing market grows, and this valuation reaffirms that statement .Even though, my analysis claims that the HD’s common stock intrinsic value is $83.58, I am still hopeful that HD can surpass expectations. Intrinsic Valuation Methods Discounted Dividends The Discounted Dividends technique of valuation has extra weight in this valuation process as compared to method of comparables, mostly because of the lack of direct competition in the industry. Price variation is not clarified adequately by dividend variation over time. Historically, the rate of growth of dividend exhibits some steadiness, so this rate was utilized in prediction of dividends. In future, stable growth in dividend is anticipated. Discounting of the future dividends back to 2004 was done using the cost of equity capital. The sum of the current value of the projected 10 years of dividends equaled to 2.75 whereas the terminal value ,which was computed with the assumption that no increase on the dividend paid equaled to 6.60.According to this model, the stock is exceedingly overvalued. However, I do not feel that approximates of the projected values of net income are very conventional. Modest growth was forecasted and this might result in future dividends being small. A sensitivity analysis of the Dividend Discount model illustrates that a 2.05 percent cost of equity capital, or a 9.8 percent growth factor in the terminal value, would be equal to the equity’s value with the market price. Though the implied cost of equity is not rational, nevertheless, growth is extremely reasonable as well as probable. Summary Through an analysis of HD’s total liabilities and assets, we realize that at present, the company has a sum of $10.788 billion in debt with liabilities standing at $22.620 billion. The total debt has reduced over the past 5 years by 19.67 percent, whereas the total liabilities have reduced by 14.99 percent. On the basis of the 5 debt ratios illustrated above, we realize that the debt ratios have grown with no red flags being shown. As the liabilities and debt have increased over the past three years, the ratios demonstrate that the growth of the company has been somewhat slower than the rise in liabilities and debt. The bond rating for HD presently stands at “A” which shows that the company has a “Strong capacity to meet financial commitments but somewhat susceptible to adverse economic conditions and changes in circumstances.” The CAPM technique for cost of equity asserts that shareholders require 6.06 percent average annually over a lengthy period of time on their equity so as to make it meaningful to invest in the company. This computation is on the basis of average market return between 1950 -2012 which stood at 7 percent. The WACC computation demonstrates that the firm compensates 5.12 percent on each dollar that it finances. Since the present HD’s WACC is 5.12 percent with a below average beta at 0.82 percent, this means that the company requires at least 5.12 percent on potential investments and will have average volatility moving onwards. On the basis of the above computations; the company has raised its liabilities and debts but at present has the potential to service its debt obligations as well as fulfill its tax responsibilities. The analysis of the liabilities and debt of HD demonstrates a company that has been reasonably raising its total liabilities and debts over the past three years. In addition, the analysis also divulges that the growth rate of the company is rising at a sluggish rate compared to its liabilities and debt. This demonstrates a high degree of risk of the company compared to 3 years ago. The S&P Bond “A” rating shows that H&D has a strong potential of meeting its financial obligations but to some extent vulnerable to severe economic conditions as well as changes in situations. The WACC discloses that H&D has the capacity to add future assets and investments at comparatively low rates. Presently, H&D has the capacity to repay its debts in addition to satisfying its other commitments while at the same time growing. Every indicator above shows a strong company that has reduced its liabilities and debt over the past 5 years, but has grown its liabilities and debt over the past 3 years. When contrasting the ratios over the past three years, they divulge that the debt levels have grown quicker than the increase in assets. These ratios demonstrate some risk to the shareholder but the CAPM shows that shareholder ought to anticipate a 6.06 percent return, every year, over the long term on their investment so as to receive good value for their capital. If H&D manages growing at a rate that is near to or more than 20 percent, its present multiple will not appear practically as rich as it may look to the naked eye with the peg ratio valuation that will be used in identifying growth with a spotlight on earnings making it attractive accordingly. As a rule of the thumb, we would think twice before purchasing as stock that is so near to longer term resistance levels. Nevertheless, instead we would choose to purchase the stock on weakness if it falls from resistance to support consequently. As long as the rate of growth is sustained, H&D appears like a buy on weakness especially when support levels are put to the test. Read More